European Central Bank raises interest rates, hints at more increases

LONDON — The European Central Bank raised its key interest rate on Thursday and hinted at more to come, the latest sign that it will not be derailed by the debt crisis in its mission to fight inflation.

The bank nevertheless agreed to extend emergency liquidity to Portuguese banks, as it has done with Greece and Ireland, even though one of the major ratings agencies downgraded the country's bonds to junk status.

Thursday's quarter point hike, to 1.5 percent, was the second this year and widely expected by markets despite a global slowdown and the debt crisis, which almost caused Greece to default this month.

While acknowledging those risks, Trichet said controlling inflation was the ECB's main job. His comments reinforced expectations that there will be at least one more interest rate increase this year as the bank tries to get inflation, which is running at 2.7 percent, back under the target of just below 2 percent.

Though higher rates may be necessary for a potentially overheating economy like Germany's, they will add to the growth concerns of the eurozone's more indebted nations, such as Greece and Portugal. Overall, Trichet said the eurozone economy grew in the second quarter, though at a slower pace than the 0.8 percent recorded in the first quarter and that uncertainty over the outlook remained elevated.

Trichet said in a press briefing the bank would "monitor very closely" price developments. He traditionally uses that phrase to indicate that the tightening cycle will continue but that rates would not rise next month.

"A further quarter point rate hike probably in October or November still appears to be the central scenario," said Marc Ostwald, market strategist at Monument Securities.

The euro rallied about a cent to $1.4364 as investors priced in the likelihood of more rate hikes at a time when the ECB's peers, such as the U.S. Federal Reserve, are showing no intention of lifting their super-low borrowing rates.

In Trichet's remarks, the issue of Greece was never far away.

Trichet, who is due to be succeeded by Mario Draghi in late October, said it was important that Greece continue with its austerity measures to take control of its public finances. Pressing hard on costs while avoiding a damaging debt default would make the Greek economy more resilient with higher growth and lower unemployment, he added.

Once again, Trichet insisted that any private sector involvement in a second bailout of Greece should be on a voluntary basis and that nothing should be done that prompts the credit rating agencies to slap a "selective default" rating on the country.

Eurozone governments are in discussions with banks and other financial institutions to get them to share part of the burden of a second Greek bailout, which is expected to be completed by September.

Even though Greece got a €110 billion ($157 billion) bailout package last year, it's going to need more money as it remains effectively locked out of international bond markets. Expectations are that the second bailout will be more or less the same size as the first.

The ECB has been criticized for its hard stance on a possible Greek debt restructuring that would compel creditors to take their share of the pain.

"An unelected ECB is casting an increasing influence on the burden sharing between the private sector and taxpayers," said Sony Kapoor, managing director of Re-Define, an economic think-tank. "This is problematic."

Trichet said, however, that the bank had suspended collateral rules for Portugal — as it already has done with Greece and Ireland — when conducting its liquidity operations, meaning the country's banks can still tap ECB cash even if Portugal's credit rating is considered junk. The move comes just days after Moody's slashed its rating on Portugal, Europe's third bailout recipient after Greece and Ireland, by four notches.

"That was the right thing to do — but for the ECB, another sign of retreat," said Gabriel Stein, an economist at Lombard Street Research.

Stein said this is the latest example of how the ECB is losing its much-vaunted independence — previously it had stressed it would not accept bonds below a minimum rating.

"Should, as we think likely, Greece or Portugal default, yet remain in the euro area, it seems just as likely that the ECB will have to accept defaulted bonds as collateral," Stein said.

Earlier in the day, the Bank of England held its base interest rate at an all-time low of 0.5 percent as the tepid economic recovery in Britain continues to outweigh concerns over inflation.

Thursday's decision by the nine-member Monetary Policy Committee to keep the rate unchanged for the 28th straight month was also anticipated in markets.

Though inflation is running at more than double the Bank's target of 2 percent at 4.5 percent, the majority of rate-setters think inflation will drop quickly next year as the impact of rising energy costs drops out of annual comparisons.